Taking the Air Out of Inflation Fears
Even though you can never be too rich or too thin, excess is not a good thing. As the S&P 500 focused on eclipsing its old high set on Mar. 24, 2000, we think any bad news that could have interfered with this record-setting run was essentially ignored. On May 30, the S&P 500 closed at 1530.23, surpassing the old mark of 1527.46. Additional closing highs were set on each of the three subsequent days.
After recouping all that was surrendered during the prior bear market, investors appeared to look for reasons to take profits. This is not uncommon. In the 10 bull markets since 1942, the S&P 500 posted an average retreat of 0.7% after establishing its first all-time high in a new bull market. Only three observations saw declines: 1949, 1966, and 1982, in which the S&P 500 fell 8.7%, 6.2%, and 2.9%, respectively, in the month following the bull market's first record high. Three and six months after all first new highs, however, the S&P 500 was up an average 2.6% and 5.2%.
Recent selling was triggered by worries over economic excess and renewed threats of an increase in inflationary expectations, in our view, as the personal spending and employment reports released June 1 indicated to some that the economy is growing more rapidly than anticipated, that the Fed would not begin lowering rates until the first quarter of 2008, and that the risk of inflation has increased.
Predicted Pullback: 5%-10%
S&P agrees that the economy looks healthier in the second quarter than it did in the first, but our full-year estimate of 2.2% real GDP growth has not changed. And while we do believe the Fed may delay its first rate cut until early next year, we continue to believe that inflation is not problematic. We forecast core CPI to advance by less than 2-1/4% in each of the coming three years. And we're not alone. The consensus of economists (tallied by Blue Chip Financial Forecasts) shares this opinion.
We therefore believe investors should not alter their investment course because of this renewed inflation concern. S&P's Investment Policy Committee recommends an allocation of 40% U.S. equities, 25% international stocks, 25% in short- and intermediate-term bonds, and 10% in cash. This stoic long-term allocation doesn't mean that the short-term sell-off has run its course. On the contrary, S&P's Equity Strategy Group believes that the pullback could total between 5% and 10% when completed. In the end, however, we believe the market will merely be taking a much needed (and anticipated) breather after eclipsing its all-time high.
A primary contributor to the recent sell-off, in our opinion, was the yield on the 10-year Treasury note moving above the 5.00% threshold; it currently trades at 5.10%. S&P believes it will challenge last summer's high at 5.25%, as 1) U.S. economic growth may have recorded its weakest results in Q1 and should improve in subsequent quarters, 2) foreign investors are likely repatriating investment assets in search of higher yields closer to home, and 3) it is also the natural progression of short- to longer-term rates.
Impact of Bond Yields
In calculating an appropriate 10-year yield level, an old rule of thumb is to start with inflation (core PCE for April was 2.0%), add two percentage points to find a "neutral" Fed funds rate (yes, we think the Fed is a bit restrictive at 5.25%), and then add 1.25% to arrive at the yield on the 10-year note: 2.0 + 2.0 + 1.25 = 5.25%.
Higher bond yields have traditionally shaken the resolve of investors for at least three reasons. First, a risk-free bond rate in excess of 5%—more than half the 9.0% average annual price gain of the S&P 500 since 1945—becomes very enticing for risk-averse investors. The higher yields rise, the greater the number of investors who become attracted to this equity substitute.
Second, the higher interest rates rise, the lower intrinsic value calculations say investments are worth. For instance, the Fed Model, which divides the earnings for the S&P 500 by the yield on the 10-year note to arrive at a fair value for the S&&P 500, currently indicates that the S&P 500 may decline as much as 10% in value when using $94.00 (S&P analysts' S&P 500 estimate of 2007 earnings) and substituting 5.25% (the projected value for the 10-year note) for 4.75% (the recent yield).
Finally, higher rates for extended periods typically weigh on future earnings as a result of increasing interest expense for companies that look to the bond market for funding to operate or expand.
Mark Arbeter, S&P's chief technical strategist, believes the rapid increase in bond yields has led to the first meaningful pullback in equity prices since late February. So far, we have seen only minor technical damage with the S&P 500 taking out short-term trendline support, as well as its 20-day exponential moving average. On June 7, the S&P 500 closed right on top of support around the 1490 level. The 50-day exponential average sits at 1492, while chart support from the mid-May low comes in at 1491.47. The next potential retracement level that may provide support is 38.2%, which targets the 1473 zone.
At worst, we think the S&P 500 could pull back to near February's highs around 1460, 2% below the June 7 close and 5.2% below the June 4 closing high of 1539.18. We believe this is a short- to intermediate-term pullback within a long-term bull market.
International Inflection Point?
On the international front, Alec Young, S&P's international equity strategist, believes stronger fundamentals will positively differentiate international equities if risk aversion continues to rise. Despite five years of torrid outperformance, international equities remain more quantitatively attractive than U.S. shares, in his view.
The MSCI EAFE (Europe, Australasia, and the Far East) Index, the leading developed international benchmark, trades at 14.6 times 2007 consensus estimated EPS, which are expected to rise a healthy 9.8% in 2007, giving it an estimated p-e to growth (PEG) ratio of only 1.5 times. Similarly, the MSCI EM (Emerging Markets) Index trades at only 13.3 times 2007 consensus estimated EPS despite consensus expectations for 15.5% 2007 profit gains, leaving it with a PEG ratio of only 0.9 times. Conversely, the S&P 500 Index trades at 16 times 2007 consensus estimated EPS and is expected to post only a 7% rise in earnings this year, equating to a lofty 2.2 times PEG ratio.
In addition, international equities sport higher dividend yields than U.S. stocks, most notably in developed overseas markets. The MSCI EAFE Index currently yields 2.7%, vs. only 1.8% for the S&P 500. The MSCI EM Index has a smaller yield advantage over the U.S. index (0.2%), reflecting EM equities' role as a capital appreciation driver within the overall portfolio, by our analysis.
A Sum-of-the-Parts Conclusion
We think this is a pause in the intermediate-term uptrend, not the end of the 4½ year bull market. S&P Economics believes inflation is not likely to accelerate beyond our expectations of 2.0%-2.5% over the coming three years, and sees U.S. real GDP advancing 3.0% in 2008, vs. a projected 2.2% rise in 2007. What's more, S&P Equity Research projects operating earnings for the S&P 500 will rise 7.3% in 2007 and 12.6% in 2008.
At a 1460 level for the S&P 500, based on Mark Arbeter's near-term support target, the "500" would be trading at 16.3 times trailing 12-month operating earnings, which would be a 14% discount to the average of 19.4 times since 1988—the first year S&P started capturing operating results. In addition, the S&P 500's p-e on 2007 estimates would be 15.5 times, while 2008's estimate would sport a 13.9 times multiple—numbers that look too attractive to dismiss, in our opinion.